Contracts for Difference

Let’s start with a briefing on Contracts for Difference [better known as CFD’s]. This is another trading instrument you may use instead of Dow E-Mini’s or ETF’s, to trade the Dow… The CFD or Contract for Difference is an investment instrument that allows traders to participate in the price movement of securities or indices without full ownership of the underlying stock or index

In many respects, a CFD works very similarly to the E-Mini future, except that the spreads can be a little wider [the bid-ask spread on an e-mini is typically 1 point, whereby the spread on a CFD can be around 2 points, which can be more expensive, but with CFD’s often the deposit/margin is considerably lower than the E-Mini, almost half!].

Similar to a future on a single stock or index and to trading stocks on margin, CFDs are an efficient approach to market participation. One can just as easily sell the stock index or security short as buy it. Online traders increasingly look to this rapidly expanding investment product as an efficient approach for market participation.

A Contract-for-Difference is exactly as the name suggests. Whenever you think [your opinion] the Dow is going to go up, it is very likely that somebody somewhere will take an opposite view to you, and think that the Dow is going to go down. This creates an opportunity to place a type of cross-trade of ‘differences in’ opinion, if you will…

Why Trade CFDs

In practical terms, investing in stocks through CFDs offers similar profit / loss opportunities as when trading stocks in the traditional manner. However, there are certain powerful advantages to consider:

Gearing
CFDs enable investors to leverage an investment up to 20 times under normal conditions. For aggressive, risk- taking investors, the ability to leverage the investment is a principal benefit of the product. Of course, the higher the level of gearing, the greater the loss or gain. Therefore, investors must be clear about the risk of trading in leveraged securities.

In effect, you can double or lose your money by a 5% move in the underlying stock or index, if you are fully leveraged on your deposit. So it is important that you choose your level of gearing carefully and only apply as much risk and money as you can afford to lose.

Short-selling
Short-selling is the act of selling a security that you do not own. Selling the market short is particularly efficient using CFDs. Investors do not need to borrow stock or pay financing costs for borrowing stock. By investing through a CFD, the investor simply clicks the sell button and buys back the CFD sometime in the future.

Instant trading
Serious investors look to CFDs for the rapid trading capability they offer – instantly tradable prices. Using online platforms, investors can hit the price immediately when it reaches the level they seek, and receive an instant confirmation of the trade at that level.

Hedging the portfolio
CFDs can be used to hedge an existing stock portfolio. Rather than liquidate or sell one’s physical stock portfolio during a period of falling prices or volatile markets, investors can quickly hedge potential risks by selling the equivalent position using CFDs for a short or long period, thus securing effective protection for their stock investments at little or no cost.

EXAMPLE 1 / Buy Intel

An investor expects the price of Intel to rally in the short term from USD 18. The investor has USD 50,000 to invest. He can now choose one of four strategies: Invest the money in stocks; Buy the equivalent number of CFDs as he would have stocks; Partially leverage his investment, e.g. five times; or Fully leverage his investment in the stock, thereby increasing his potential investment to USD 500,000 (on a 10% margin), and also raising the related risks by the same factor.

The graph below compares the outcome of a few CFD strategies with a traditional stock investment. After the opening transaction, Investor 1 & 2 have an exposure of 2,000 shares in Intel, while Investor 3 & 4 stand to profit from a leveraged holding of Intel shares for the same amount deposited. Of course, the risk for Investor 3 & 4 is significantly higher as well.

With the same capital available you can get very different results depending on the level of risk you are willing to take. Please remember to only leverage your investment as much as you can afford to lose if the position moves against you.

EXAMPLE 2 / Sell IBM

An investor considers IBM overvalued at USD 77 and speculates on a lower price. He seeks to leverage his investment five times (up to 10 times is possible), allocating USD 50,000 to the trade

The graph below shows results from three short-selling

* The financing rate will change with interest rates in the base currency. The above calculation is intended for illustrative purposes and is not 100% accurate.

Note that the financing is now added to the profit as you receive interest on short positions.

Trading Dow CFDs

Taking a quick example… Assume, on Monday you saw a BUY opportunity in the Dow on your screen, which tells you that it is likely to go up. Somebody else, an individual just like you, somewhere [anywhere in the world] thinks the Dow is going to go down, for whatever reason…

Now, in order for the two individuals to do a trade, one needs an ‘agent’ who puts the person who thinks the market is going to go up [you] with the person who thinks the market is going to go down [the other person]. This agent is the ‘broker’ or better known as a CFD-dealer. With state of the art computers, this ‘agent’ can see on his screen any person who wants to back his judgment that the market is going to go up, and another person who wants to back his judgment that the price is about to go down. The agent can potentially put the deal together, run a ‘book’, so to speak.

You can trade any leading stock using the CFD. And indeed, you can simply trade the Dow [or any other popular index].

Assume the Dow stands at 10800 points, you think it will go up, and the other person thinks it will go down. Now, once you enter the market to take an ‘up’ position, the CFD-dealer simply matches you with the person who is taking a ‘down’ position. This matching thus neutralizes the dealers’ position so his risk is zero. He is simply the ‘middleman’ or matchmaker. For his trouble in matching the two parties, he charges what is known as a ‘spread’…

So, with the Dow at 10800, he will quote two prices, eg., 10798-10802. This means [just like an E-Mini] 10798 to take a ‘down’ position, and 10802 to take an up position. That is a difference of 4 points. This is simply his profit margin [similar to an estate agent or realty agent who puts a buyer and seller together and takes a tiny ‘cut’]. There is always a two-way price quote [or bid & ask]…

In this example, the person who takes the ‘up’ position buys at 10802, the other person takes the ‘down’ position at 10798. The difference of 4 is the market-makers commission/cut.

A plus point about CFD’s [depending which way you look at them] is that they also offer ‘margined’ trading. You need only put up small margin requirements to trade them. For instance, a CFD provider might require 150 points x your $per point position to cover initial deposit/margin. So, if you trade at $5 per point, then that means deposit = $5 x 150 = $750, which is less than half that required to trade the E-Mini. However, on the flip-side look out for wider bid-ask spread margins, which is effectively a ‘cost’.

Please note that CFD trading does require at least some experience from the brokers, to prove that you do fully understand the risks/rewards of this instrument [this experience could be in trading shares, or spread-bets, Dow futures, ETF’s etc.